Friday, 30 November 2007

Recent newspaper reports tell us that as from January 3, imported used cars made before 1998 will in effect be banned, unless they meet emissions standards to be toughened in 2009 and 2012. This is because of Government imposed limits on exhaust emissions introduced in a bid to cut pollution.

But will emissions be cut?

The ban on imported cars will reduce the supply of cars available on the New Zealand market. This will increase the price of used cars which will make it dearer for people to replace their old cars. Thus people will keep using their old, high emission, cars longer than they otherwise would have. It may turn out that keeping the old high polluter cars on the road longer may not lead to the reductions in pollution the government hopes for.

In Foreign Policy Russ Roberts attempts to explain, in around 1000 words, why we trade. He tries to explain the relative importance of imports and exports and the total unimportance of the trade deficit.

Gavin Kennedy continues to rightly find fault with peoples use of the Smith's invisible hand metaphor. But this time he writes "The elision of Adam Smith's metaphor in a theory of markets was a creation of modern neo-classical economists, centred on Chicago University, who found in the use of the metaphor some kind of justification of their mathematical theories of general equilibrium."

But I would not think of Chicago as the centre of "mathematical theories of general equilibrium". I would have seen Chicago as having more of an emphasis on basic price theory in its partial equilibrium form. General equilibrium followed from Walras's work and found its modern form in the works of McKenize, Arrow and Debreu etc. This is not, to my way of thinking, the Chicago tradition. Overtveldt (2007: 93-4) makes the point that "At the end of World War 11, the Cowles Commission for Research in Economics was installed at the University of Chicago. The fact that leading members of this Commission - such as Jacob Marschak, Trygve Haavelmo, Lawrence Klein, and Tjalling Koopmans - were heavily involved in the development of Walrasian general equilibrium economics and building sophisticated econometric models was a constant source of friction between them and the group around Friedman at the University of Chicago's department of economics." The Commission left and Friedman stayed.

Peter Klein at the most interesting blog, Organizations and Markets is writing on the nonprofit firm. What is their objective function? How are they organized, managed, and governed?

Klein points out that there is a new NBER paper out by Jill Horwitz and Austin Nichols, "What Do Nonprofits Maximize? Nonprofit Hospital Service Provision and Market Ownership Mix". It looks at the behaviour of nonprofit, government, and for-profit hospitals to address the questions asked above. The major result is that nonprofit and government-owned hospitals respond to competition; the more local-market competition they face from for-profit hospitals, the more likely they will offer profitable services and the less likely they will offer unprofitable services. For-profit hospitals, however, tend to offer the same mix of services regardless of what competing for-profit hospitals are offering.

Every first or second year microeconomics text book has a chapter on the "theory of the firm" which doesn't make sense since the 'firm' doesn't really exist in neoclassical theory. There is a theory of supply, but no real theory of the firm.

As has been pointed out by Demsetz (1982, 1988 and 1995) before Knight (1921) and Coase (1937) the fundamental preoccupation of economists was with the price system and hence little attention was paid to the firm as a separate, important, economic entity. Firms existed as handmaidens to the price system.

The interest in the price system, culminating in the "perfect competition" model, has its intellectual origins in the eighteenth-century debate between free traders and mercantilists. This debate wasn't about competition, in any meaningful sense, and it wasn't about the existence and organisation of the firm; it was about the proper scope of government in an economy, and the model it gave rise to reflects this. The central question of the debate was, Is central planning necessary to avoid the problems of a chaotic economic system? Adam Smith famously answered no.

For Smith, markets are one very prominent mechanism for solving the problems of coordination and motivation that arise with interdependencies of specialisation and the division of labour. Market institutions leave individuals free to pursue self-interested behaviour, but guide their choices by the prices they pay and receive. The following 200 hundred years amounted to a closer examination of the conditions necessary for the price system to be able to avoid chaos.

The formal model that arose from this examination is one which abstracts completely from any form of centralised control in the economy. It is a model delineated by "perfect decentralisation". Authority, be it in the form of a government or a firm or a household, plays no role in coordinating resources. The only parameters guiding decision making are those given within the model - tastes and technologies - and those determined impersonally on markets -prices. All parameters are outside the control of any of the economic agents and this effectively deprives all forms of authority a role in allocation. This includes, of course, the firm. It doesn't matter whether it is general equilibrium, characterised by Walras's auctioneer, or partial equilibrium, characterised by Marshall's representative firm, there is no serious consideration given to the firm as a problem solving institution.

In neoclassical theory, the firm is a 'black box' there to explain how changes in inputs lead to changes in outputs. The firm is a conceptualisation that represents, formally, the actions of the owners of inputs who place their inputs in the highest value uses, and makes sure that production is separated from consumption. The firm produces only for outsiders, there is no on the job or internal consumption, no self-sufficiency. In fact there are no managers or employees to indulge in on the job consumption and as production is separated from consumption, no self-sufficiency. Production for outsiders is, according to Demsetz (1995), the definition of a firm in the neoclassical model: "[w]hat is needed is a concept of the firm in which production is exclusively for sale to those formally outside the firm. This requirement defines the firm (for neoclassical theory), but it has little to do with the management of some by others. The firm in neoclassical theory is no more or less than a specialized unit of production, but it can be a one-person unit." (Demsetz 1995: 9). As inputs are combined in the optimal fashion by the actions of independent owners of inputs motivated solely by market prices, there is no need for 'management of some by others', there is no role for managers or employees. Also note that as competition assures the absence of profits and losses in equilibrium, there is no need to have a residual claimant. This means that, in one sense at least, there are no owners of the firm. As there are no physical assets controlled by the firm, there are no (residual) control rights over these assets to allocate. This implies there are no owners of the firm in the Grossman/Hart/Moore sense.

Hart (1995) criticises the neoclassical model based on three characteristics of the theory. First, he notes that the theory completely ignores incentive problems within the firm. The firm is a perfectly efficient 'black box'. Second, the theory has nothing to say about the internal organisation of the firm. Nothing is said about the hierarchical structure, how decisions are made, who has authority within a firm. Third, the theory tells us nothing about how to pin down the boundaries of the firm. The theory is as much a theory of plant or division size as firm size. As Hart points out "[t]o put it in stark terms ... neoclassical theory is consistent with there being one huge firm in the world, with every existing firm ... being a division of this firm. It is also consistent with every plant and division of an existing firm becoming a separate and independent firm." (Hart 1995: 17).

Cyert and Hedrick (1972) addressed similar points. They argue that in the neoclassical system the firm doesn't exist, that no real world problems of firms are considered, that there are no organisational problems or any internal decision-making process at all. "In one sense the controversy over the theory of the firm has arisen over a non-existent entity. The crux of microeconomics is the competitive system. Within the competitive model there is a hypothetical construct called the firm. This construct consists of a single decision criterion and an ability to get information from an external world, called the "market" [8, Cyert and March, 1963, pp. 4-16]. The information received from the market enables the firm to apply its decision criterion, and the competitive system then proceeds to allocate resources and produce output. The market information determines the behavior of the so called firm. None of the problems of real firms can find a home within this special construct. There are no organizational problems nor is there any room for analysis of the internal decision-making process." (Cyert and Hedrick 1972: 398). Thus within the neoclassical model of the price system, the firm's only role is to allow input owners to convert inputs into outputs in response to market prices. Firms have no internal organisation since they have no need of one, they have no owners since there is nothing to own. Questions about the existence, definition and boundaries of the firm are to a large degree meaningless within this framework since firms, by any meaningful definition of that term, don't really exist.

As Foss, Lando and Thomsen (1998) summarise it: "The pure analysis of the market institution leaves almost no room for the firm (Debreu 1959). Under the assumption of a perfect set of contingent markets, as well as certain other restrictive assumptions, the model describes how markets may produce efficient outcomes. The question how organizations should be structured does not arise, because market-contracting perfectly solves all incentive and coordination issues. By assumption, firm behaviour (profit maximization) is invariant to institutional form (e.g. ownership structure). The whole economy can operate efficiently as one great system of markets, in which autonomous agents enter into very elaborate contracts with each other. However, by treating the firm itself as a black box, where internal structure, contracts, etc. disappear from the picture, there are many other issues that the theory cannot address. For example, the theory does not tell us why firms exist." (Foss, Lando and Thomsen 1998: 1-2).

Thus we see the dichotomy between theory and practice: in practice the firm is the "dominant feature of the landscape" while in the neoclassical theory, the 'firm' does not exist.

Thursday, 29 November 2007

Eric Crampton gave an excellent speech to the Christchurch anti Electoral Finance Bill rally yesterday. He took a look at the bill from the perspective of public choice. He found the bill wanting on a number of issues. Text of his speech is below:

It takes a lot to drag an academic economist out of his office to a political rally downtown. If this were simply a protest over bad legislation, I'd have stayed in Ilam: bad legislation, unfortunately, isn't all that uncommon.

And, this is very bad legislation - so bad that, even after amendment,the New Zealand Law Society wants it scrapped. This is amazing. When law is badly drafted, it's the lawyers that profit by the resulting court battles. Lawyers from Chapman Tripp warn that the courts may well decide the next election - they expect court action. Legislation has to be shockingly bad before we'd expect lawyers to say it should be scrapped entirely, but that's what they've done. Even the Electoral Commission, who has to give advice on compliance with the legislation, is reported to have thrown up its hands: it can't make heads or tails of the legislation either, and so can't provide advice.

Even worse, the legislation seems pointless.

The best social science evidence shows that donations to political parties don't buy the donor a whole lot in terms of changes in policy. And, when sitting politicians spend money on election campaigns, the spending doesn't have a very big effect on vote share. Spending can matter a lot for challengers, who have to work very hard to get their names known. But, spending doesn't matter much for incumbent politicians.

Further tightening up of campaign spending rules, and especially changes like the ones now proposed that allow political parties to use Parliamentary budgets for electioneering, protect sitting MPs against challenges by newcomers. It's an incumbent protection racket plain and simple. New parties and new ideas will be frozen out, and the same old hacks are guaranteed job security.

As bad as all of that is, it's not the main reason I'm here.

This isn't just bad law. It's a bad law that affects how we make laws, and threatens the legitimacy of government itself. Constitutional rules stand apart from other bits of legislation. They affect fundamental rights and freedoms, and they set out how all the other rules will be written. The Electoral Finance Bill directly affects our freedom of speech. Once it's passed, we'll only have freedom of speech 2 years in 3. And, it sets out the rules for how an election is conducted - how legislation for the subsequent three years will be formed. These have constitutional implications.

Constitutional rules aren't like other rules. They really require broad agreement across society. I studied under James Buchanan, who won the Nobel Prize in economics for his work in this area. He likened it to setting out the rules for a poker game: you get everybody to agree to the rules before you deal the cards. If everybody's agreed to the rules before the cards are dealt, the outcome of the game is fair and legitimate. What Labour and its support parties here have done is dealt the cards, taken a peek at their hands, and then declared deuces wild. This violates constitutional justice and threatens the legitimacy of any government that is elected under the new rules.

Electoral rules - constitutional rules - require broad agreement if the government that's formed under them is to have legitimacy. We're here today to say that we don't give that assent. If Labour rams this bill through Parliament, shuts up anyone who opposes it during the 2008 election, then squeeks through a tight coalition win after a lot of litigation, will that government have any legitimacy?

That's why this Bill must be stopped and that's why I'm here. The Bill violates the spirit of our constitutional foundations. It throws freedom of speech out the window. And it rigs the election to protect the politicians who pass it. Helen Clark, Annette King, throw out this Bill!

Gavin Kennedy blogs on Adams Smith's view of joint stock companies. Kennedy puts things in context by pointing out that Smith’s criticism of joint stock companies concentrates on the chartered trading companies, under Royal Warrant or Act of Parliament, such as the East India Company, with side-swipes at other chartered trading companies governing British trade with other parts of the world. Kennedy also points out that Smith accepted the benefits of joint stock companies for other purposes.

It has been pointed out in that asymmetric information can create rather than destroy markets. But we can push the argument further and consider asymmetric information and the firm.

Asymmetric information is not a problem for the firm but an essential way for it to operate. Harold Demsetz ('The Theory of the Firm Revisited', "Journal of Law, Economics, and Organization", 4(1) Spring: 141-61) recognised this when he noted that given the limitations on what a single worker can know, the total competence that a firm has to possess, must be divided up into bits which are manageable. Each bit is allocated to groups of workers and their actions co-ordinated by management. Thus workers who produce on the basis of knowledge they themselves do not possess, have their activities directed by someone who does possess (at least more) of the necessary knowledge. In this way direction is a substitute for education, that is for the transfer of the knowledge itself. Specialisation in knowledge not only exacerbates asymmetric information, it actually demands it.

Everyone can not and should not know everything. The organisational issue this creates for the firm is to ensure that the worker with information reveals it fully to those who need to know it. In their book "Saving Capitalism From the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity" Rajan and Zingales point out that we are in fact seeing a new "kinder, gentler firm". This is in response to the increase in the importance of knowledge in the form of human capital, increased competition and access to finance, all of which have increased the worker's importance and improved the outside options for workers, thereby changing the balance of power within firms. In Rajan and Zingales's view "[t]he single biggest challenge for the owners or top management today is to manage in an atmosphere of diminished authority. Authority has to be gained by persuading lower managers and workers that the workplace is an attractive one and one that they would hate to lose. To do this, top management has to ensure that work is enriching, that responsibilities are handed down, and rich bonds develop among workers and between themselves and workers". Only by such methods can management set incentives in the hope of enticing full revelation of information by employees.

The need for setting incentives for information revelation is not new, its not just an artefact of the so-called knowledge economy. In discussing the factory system of the industrial revolution Joel Mokyr observes that "[p]utting all workers under one roof ensured repeated interaction and personal contact provides maximal bandwidth to maximize the chances that the information will be transmitted fully and reliably. Inside a plant agents knew and could trust each other, and this familiarity turned out to be an efficient way of sharing knowledge." (The Gifts of Anthena: 141) This is an interesting example of using social based incentives to help deal with a asymmetric information problem.

Asymmetric information is therefore the result of the importance of knowledge in the production process. As long as no one person can know the entire production process then situations of asymmetric information must occur. The division of labour is limited not only by the size of the market but also by the size of the knowledge set required to carry out the best-practice mode of production. The smaller the knowledge set, the less the division of labour and the less is the "problem" of asymmetric information.

From first year on, economics students are told that asymmetric information can cause markets to fail. Akerlof's famous example of the used car market is known to all econ students. But does asymmetric information really cause market failure or does it in fact cause markets to exist?

The great Austrian economist Friedrich Hayek would surely argue the latter, markets are the answer to the problem of asymmetric information.

For Hayek markets eliminate the asymmetry by revealing relevant aspects of information in market prices, but not so for the Akerlofs of this world. As Cowen and Crampton (2002: 5) put it "[t]he Canadian plumber's knowledge of substitutes for copper piping influences the French electrician's choice of home wiring through its effect on the market price of copper. For the market failure theorists, however, asymmetry cannot be overcome by exchange precisely because the unequal distribution of information interferes with mutually beneficial exchange." The fundamental point of markets for Hayek is that they utilise dispersed, asymmetric, knowledge in such a manner as to align production plans with consumption plans.

This alignment takes place in three ways: "First, ex ante, prices transmit knowledge about the relative scarcities of goods to various market participants so they may adjust their behavior accordingly. If the price of a good goes up, this informs economic actors that the good has become relatively more scarce and that they should economize on its use. For this reason, participants in the market have an incentive to include the knowledge contained in prices in their actions over time. Second, the price system serves the ex post function of revealing the ultimate profitability or unprofitability of economic actions. Prescient entrepreneurship (in the broad sense of the term) is rewarded with profits; errors are penalized by losses. Market prices, therefore, not only motivate future decisions by conveying information about changing market conditions, but also help market participants evaluate the appropriateness of past market decisions and correct erroneous ones. Seen in this light, the market process is a matter of dynamic adjustment. What is it adjustment to? It is, in effect, adjustment to the gaps between a static equilibrium of universal satisfaction and the many departures from this model that are present in the real world. Each of these gaps between the counterfactual and the factual represent a profit opportunity. Price information is also motivation for profitable real-world adjustment, over time, to the profit opportunities of a particular place." ( Boettke 1997: 25-6)

Also new markets can develop to deal with asymmetric information, if you don't know the condition of a second hand car you take it to the AA and get a report on what's right or wrong with it. If you don't know what maybe wrong with a house you want to buy you can get that checked as well. These services have developed to deal with the asymmetric information in the used car and housing markets. The basic point is that markets constantly innovate, informational asymmetries create demand for product assurance from which profits can be made by alert entrepreneurs. Klein (2001) is one paper which looks at the institutions that have arisen in the market system to mitigate problems of information, quality and certification. The lesson to be drawn here is that while "[m]arket failure theory predicts massive deadweight losses accruing from the trades that fail to take place because of informational asymmetries. In reality, alert entrepreneurs see deadweight losses as potential profits to be earned by removing the impediment to trade." (Cowen and Cramption 2002: 12-3)

So who's more likely to be right, Akerlof or Hayek? Ask yourself, Can you buy a good used car?